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Government-sponsored enterprises (“GSEs”), such as Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortgage Corporation), and the Federal Home Loan Bank System are shareholder-owned corporations, working under a Congressional corporate charter. Each of these entities serves as an instrument of national housing policy to facilitate homeownership. They provide funds for low-cost mortgages to low/moderate and middle-income Americans. Fannie Mae and Freddie Mac are the two largest entities of their kind and their rapidly increasing debt load represents forty percent of the investment grade bond market.
Currently, GSEs use derivative instruments to supplement their debt issuance, to hedge their interest rate and prepayment risks, and to manage their bond duration profile. They use interest rate swaps to transform short-term debt into synthetic long-term debt, and option-based derivatives to hedge prepayment and loan default activity on their assets. Fannie Mae has reported that the aggregate notional amount of its derivatives portfolio as of year-end 2003 was $1.04 trillion, accounting for approximately 0.5% of the entire global derivatives market.
Given the extraordinary volume of derivatives on GSE balance sheets, any instability GSEs may experience is likely to cause systemic ripples among its counterparties. Extensive use of derivative instruments and the lack of transparency of the derivative instruments have raised concerns among policy makers who are uneasy with the growth in debt load and counterparty hedge exposures. The numbers are large and the interest rate swaps, options, and caps counterparties use as financial tools may no longer be sufficient to offset the expanding debt the GSEs carry and the counterparties (e.g., the several largest United States banks) ensure.
Low interest rates and the continued rise of homeownership have led to rapid growth in the mortgage market in recent years coupled with an increasing rate at which mortgages are being refinanced. Since, Fannie Mae and Freddie Mac dominate the mortgage market, any instability among these entities could cause significant financial stress in the United States. Instability in similar international enterprises could cause stress in financial systems worldwide.
In 1994, the U.S. General Accounting Office expressed concern that failure by a large end-user of derivatives could lead to the following sequence of events: 1) one or more dealers who are counterparties could default, causing a chain reaction of counterparty defaults; 2) the opaqueness of derivatives and increased uncertainty associated with these derivatives could result in a general lack of liquidity or a freeze-up of over-the-counter derivatives markets, forcing dealers and others to use the more liquid exchange-traded futures and options markets, and leading to price breaks in those markets; and 3) price breaks in such markets could spread to markets for other assets and create widespread uncertainty about asset values, which could generate widespread panic which, in turn, could lead to widespread selling and plunging asset values throughout the world.